Reconsidering Europe ETFs

The Guggenheim CurrencyShares Euro Trust (NYSE:FXE) is up 2.7 percent year-to-date and that is just one data point underscoring the difficult environment faced by equity-based Europe ETFs this year, particularly those of the currency-hedged variety.

Not surprisingly, the European Central Bank (ECB) is seen as the culprit behind euro strength and subsequent weakness for Europe ETFs such as the WisdomTree Europe Hedged Equity Fund (WisdomTree Inter Hedged Eq Fund (NYSE:HEDJ)). Last week, the ECB again disappointed investors by leaving its $1.9 trillion stimulus program unchanged. Perhaps making matters worse is the fact that ECB President Mario Draghi said the central bank did not even consider fresh stimulus.

Rethinking The Situation

Still, reasons remain regarding why investors should not throw in the towel on Europe ETFs, not the least of which is more favorable pricing today than what was available a year ago. In the case of HEDJ, there is more to the story, including the ETF's underweight to the financial services, which is a plus in the current environment for eurozone equities.

Although some new reforms and regulations are seen as steps in the right direction for the eurozone's fractured banking systems, the time it takes for investors to realize the rewards of such efforts can be trying on their patience.

HEDJ's exporter tilt causes a significant under-weight in the Financials sector relative to cap weighting. Through 2016, we have seen this under-weight in Financials average roughly 8 percent. The WisdomTree Index has 0 percent exposure to Italian banks versus the 2 percent allocated by the MSCI EMU Index. To put the significance of these under-weights into perspective, year-to-date, European financials are down 14 percent, while Italian financials are down 37 percent measured in euros, according to a recent WisdomTree note.

Due to its emphasis on higher quality, dividend-paying exporters, financials account for just 12.7 percent of HEDJ's weight compared to weights of over 18 percent apiece for industrial and consumer staples names.

Data suggest HEDJ's methodology works. Over the past three years, not only has HEDJ been slightly less volatile than the MSCI EMU Index, the WisdomTree ETF has outperformed that index by an almost 20-to-1 margin. That serves as a reminder of the unintended consequences of investors not acknowledging currency risk.

While future movements in the European currency are hard to predict, our research suggests that taking currency risk in Europe is not advised over longer-term holding periods. Put another way, currency exposure in Europe is a source of risk with no expected long-term return, added WisdomTree.

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